Questor share tip: Get in quick and buy Royal Mail shares

Investors should act quickly to ensure they don't miss out on this income
stock, says Questor

Professional investors took just three hours to fill their allocation of Royal Mail shares, but if you are private investor don't despair.

There is still time to get your hands on shares in a company that looks set to become a solid income stock.

Royal Mail said it expects to pay a full year dividend of £200m, around 20p per share, which would yield between 6.1pc and 7.7pc given the share price range.

The Royal Mail has a dominant market position giving it pricing power. It controls 99pc of the UK letter market and is a market leader in parcels.

Royal Mail has a solid core business. Letter volumes may be in structural decline with volumes down between 4pc and 6pc a year, but stamp price increases that are inflation linked are offsetting this. Letter revenue actually increased 3pc in the year ended March 2013.

The Parcel operation is enjoying strong growth and volumes are forecast to increase by 5pc a year as more people shop online and opt for home delivery.

That means the UK Parcel, International and Letters business, responsible for 84pc of revenue and three quarters of profits, is profitable and cash generative. The cash levels are expected to reduce net debts – total borrowings less cash – from £903m at March 31 to around £600m by March 2014.

Profitability is also expected to improve. Group profit margins of 4.4pc in the year ended March 31, are expected by analysts to improve by 0.5pc over the next five years.

The strike action is a concern but the price outweighs this, buy.

WHAT ARE INVESTORS BUYING?

The first and most important question is always what am I buying? Royal Mail has two main businesses UK Parcel, International and Letters (UKPIL), responsible for 84pc of revenue and employing 150,000 people and General Logistics Systems (GLS) responsible for 16pc of revenue.

UK Parcel, International and Letters (UKPIL)

UKPIL is split between letters, parcels and marketing mail. The letter industry is in structural decline with overall volumes falling between 4pc to 6pc every year. However, Royal Mail has a monopoly over letter delivery in the UK. This gives them pricing power and in April 2012 the group was largely freed from revenue controls and stamp price increases were allowed. This meant that letter operations increased revenue by 3pc to £4.79bn despite volumes falling 8pc in the year to March 31.

Parcelforce is the Royal Mail’s branded parcel delivery company and it is providing exciting growth. Royal Mail with 53pc of UK parcels has a market leading position. The rise and rise of internet shopping is boosting home delivery. The Parcel operation increased revenue by 13pc to £2.98bn as it delivers more than 3 million parcels every day. However, this business does face stiff competition from the likes of DHL and Fedex.

Marketing mail operations are subdued due to a depressed advertising market. Marketing operations delivered a solid performance with stable revenue. However, any recovery in the advertising market will boost business here.

General Logistics Systems (GLS)

GLS operates as a parcel delivery operation across Europe. Competition in this region is tough and profit margins slipped to 6.7pc from 8.2pc in the year ended March 31. The division generates 16pc or £1.5bn of group revenue and around a quarter of operating profits.

ARE THE SHARES EXPENSIVE?

On first take they look priced to go. The government wants a successful flotation and the pricing looks reasonable. On Questors' calculations the company looks set to be valued at around 7 times earnings before interest and tax (EBIT). That compares with European rival Deutsche Post DHL trading on 11.3 times forecast EBIT, and Belgian operator Bpost on 6.9 times EBIT. The important factor to note here is that direct comparisons are difficult because Royal Mail does not enjoy the same exposure to parcel growth in Asia through DHL as Deutsche Post.

WHERE NEXT FOR THE SHARES?

Demand for the shares is very strong. Orders from institutions filled the order book within three hours of opening. Retail investors don't need to worry because they have an allocation of 30pc of the float, but they should act quickly. What you are buying is a core UK letter operation that is stabilising and generates cash, and a parcel operation that is plugged into a growth market. So profits should be underpinned with revenue buoyed by improved pricing and parcel growth. That leaves the forecast dividend of around £200m, giving a yield of more than 6pc, more than two times covered by earnings of £403m. Royal Mail looks set to become a nice little income stock.